Draft decision on WACC for gas and electricity services

Commission releases draft decision on the WACC used
for regulation of electricity lines and gas pipeline
services

The Commerce Commission has released
and is now seeking submissions on its draft decision on the
weighted average cost of capital (WACC). The WACC is used in
the price-quality path and information disclosure regimes
that apply to businesses regulated under Part 4 of the
Commerce Act 1986.

The draft decision proposes reducing
the WACC used to determine price-quality paths for
electricity lines and gas pipeline services. The WACC used
will be the estimate at the 67th percentile of the WACC
range rather than the current 75th.

The proposal is now
open to submissions, with the Commission’s final decision
due in October. The final decision will affect the prices
electricity lines businesses can charge from April next
year, and from 2017 for gas pipeline businesses.

“The
proposed change in the WACC percentile would reduce consumer
bills by about $33m per year across both electricity lines
and gas pipeline services, without compromising efficient
investment or service quality,” said Commerce Commission
Deputy Chair Sue Begg.

“At the same time, regulated
businesses subject to price-quality paths would see their
rate of return reduce by about 24 – 28 basis points per
annum. The decision aims to strike the right balance to
ensure on-going investment while constraining excessive
profits.”

The Commission’s work on WACC was in
response to the High Court judgment last year which
questioned the WACC estimate. The Court considered that the
use of the 75th percentile was insufficiently supported by
evidence, and might be at odds with the Part 4 objective to
limit the ability of regulated suppliers to earn excessive
profits.

“Our draft decision today takes account of
evidence not available at the time the WACC input
methodology was originally set, back in December 2010,”
said Ms Begg. “The decision also builds on additional
expert views that were commissioned to help inform our
decision. These reports are all available on our website,
and the public can express their views on these as part of
their submissions.”

The Commission’s draft decision
also proposes that, under information disclosure regulation,
the 33rd to 67thpercentile WACC range is used to assess the
profitability of electricity lines and gas pipeline
businesses.

Submitters will be able to provide their views
on the draft decision by 29 August 2014. Cross submissions
will be accepted up to 12 September 2014.

The Commission
intends to have the final decision released in time to be
incorporated into its final decisions on price-quality paths
for electricity lines businesses in late November.

You can
find the draft decision on the Commission’s website, as
well as copies of the expert reports on theFurther work on WACC page.

Part
4Part 4 of the Commerce Act 1986 regulates
a number of markets where competition is limited, including
electricity lines services, gas pipeline services and
specified airport services. The intention of Part 4 is to
ensure that suppliers have incentives to innovate, invest,
improve efficiency and produce quality services for
consumers, while also limiting their ability to extract
excessive profits.

Some of the services regulated
under Part 4 are subject to price-quality paths (electricity
lines services and gas pipeline services). This means the
Commission restricts the revenue a regulated business can
earn or sets the maximum average prices it can charge, as
well as setting service quality standards that must be met.
Other regulated services (Wellington, Auckland and
Christchurch airports) are only subject to information
disclosure which means they must publish certain information
about their performance.

Part 4 also requires input
methodologies to be set to promote certainty for regulated
businesses and other interested parties. More information on
input methodologies is provided below.

Input methodologiesInput
methodologies are a range of upfront regulatory rules,
processes and requirements covering matters such as the
valuation of assets, the treatment of taxation, the
allocation of costs, and the cost of capital. Part 4 of the
Commerce Act requires the Commission to set input
methodologies for specified airport services, electricity
distribution and transmission, and gas pipelines. The
Commission must review each input methodology no later than
seven years after its date of publication and, after that,
at intervals of no more than seven years.

WACC percentile estimateThe
cost of capital is the financial return that investors
require from an investment given its risk. Investors have
choices, and will not invest in an asset unless the expected
return on that asset is at least as good as that they would
expect to get from a different investment of similar risk.
The WACC reflects the cost of debt and the cost of equity,
and the respective portion of each that is used to fund
investments in the assets used to supply regulated
services.

The WACC cannot be observed; it must be
estimated, so there is a risk that the estimate is higher or
lower than the true (but unobservable) WACC. To mitigate
this risk the Commission calculates a distribution around
the mid-point WACC estimate based on the standard errors of
some of the key parameters. This defines a WACC range. A
percentile in this WACC range distribution is then chosen,
based on what best meets the purpose of Part 4. It is a
change to this percentile that the Commission is currently
proposing.

As it stands, the current cost of capital
input methodologies require that the Commission apply the
75th percentile estimate of the WACC range (‘75th
percentile’) when setting default or customised
price-quality paths applying to electricity distribution
businesses and gas pipeline businesses, or the individual
price-quality path applying to Transpower. Electricity
price-quality paths (excluding Orion) must be reset by the
end of November this year.

The cost of capital input
methodologies also require the Commission to publish 75th
percentile WACC estimates, mid-point WACC estimates and 25th
percentile WACC estimates for all suppliers that are subject
to information disclosure regulation. ‘Consumer-owned’
electricity distribution businesses and the three main
international airports are subject to information disclosure
regulation only. In the Commission’s recent reports on how
effectively information disclosure regulation is promoting
the Part 4 purpose in respect of specified airport services,
the Commission assessed airport profitability against a WACC
range from the mid-point to the 75th percentile.

Reviewing the WACC estimate: steps in the
process so far

In its December 2013 judgment
on the Commission’s input methodologies, the High Court
suggested that using the 75th percentile estimate of the
WACC may be at odds with the Part 4 objective to limit the
ability of regulated suppliers to earn excessive
profits.

Following consultation with stakeholders
about the implications of the judgment, on 31 March this
year the Commission issued a notice of intention to do
further work on the input methodologies relating to the
percentile estimate of the WACC. The Commission considered
this work to be necessary to address the uncertainty for
investors that will exist until the question of the
appropriate percentile is resolved.

On 23 June the
Commission released a further process update paper, and a
number of expert reports written for the Commission on the
choice of the WACC percentile. The reports were prepared by
a number of expert advisers and firms engaged by the
Commission: Professor Ingo Vogelsang of Boston University,
Professor Julian Franks of the London Business School,
Associate Professor Martin Lally of Victoria University of
Wellington, European economic consulting firm Oxera, and the
Australian consultancy Economic Insights.

On 11 July
the Commission released a peer review by Professor Vogelsang
of Oxera’s analysis on the WACC percentile.

The
consultation material to date on the WACC percentile,
including the notice of intention and the expert reports,
can be viewed on the Further work on WACC page.

Airports
regulation is not covered by this draft
decision

As notified in the process update
paper on 23 June, the draft decision does not cover the WACC
percentile for information disclosure regulation of
airports. The Commission considers that given the
combination of its different industry characteristics and
its regulatory regime the airports decision should be
considered in its own right at a later
date.

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